PORTFOLIO

Cafeteria Plans (Portfolio 397)

Tax Management Portfolio, Cafeteria Plans, No. 397-3rd, examines the federal income taxation of “cafeteria plans” under Code §125. The Detailed Analysis includes an overview of the history of Code §125. It then examines in depth the development of the rules governing cafeteria plans, including the rules that govern the different types of benefits that may be provided under them.

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DESCRIPTION

Tax Management Portfolio, Cafeteria Plans, No. 397-3rd, examines the federal income taxation of “cafeteria plans” under Code §125. The Detailed Analysis includes an overview of the history of Code §125. It then examines in depth the development of the rules governing cafeteria plans, including the rules that govern the different types of benefits that may be provided under them. The Detailed Analysis includes an in-depth discussion of the relevant Code provisions and the IRS's cafeteria plan regulations and their planning implications. The Worksheets include relevant practice aids, such as model plan documents. Tax Management Portfolios on related topics include:

 

• 358 T.M., Cash or Deferred Arrangements;
• 386 T.M., Insurance-Related Compensation;
• 394 T.M., Employee Fringe Benefits; and
• 395 T.M., VEBAs and Other Welfare Benefit Funding Arrangements.


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AUTHORS

DAVID L. RAISH
David L. Raish, B.A., Yale University (1969); J.D., Harvard Law School (1973); member, Massachusetts and District of Columbia Bars, and the Tax Sections of the American Bar Association and Boston Bar Association.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

A. Scope of Discussion

B. Brief Description of Cafeteria Plans

1. Employee Choice

2. Benefits Offered

3. Salary Reduction

4. Insurance Options

5. Reimbursement Accounts

C. Federal Income Tax Advantages

D. Overview of Statutory Requirements

1. Statutory Definition

2. Permissible Benefits

3. Impermissible Benefits

4. Nondiscrimination Rules

II. Evolution of the Current Cafeteria Plan Rules

A. Cafeteria Plans Prior to the Revenue Act of 1978

1. Proposed Salary Reduction Regulation

2. ERISA Moratorium

3. Extension of Moratorium

B. Revenue Act of 1978

C. 1984 Developments

1. February 1984 News Release

2. May 1984 Proposed Regulations

3. The Tax Reform Act of 1984

D. Tax Reform Act of 1986

E. 1987 Proposed Legislation

F. Technical and Miscellaneous Revenue Act of 1988 (TAMRA)

G. 1989 Proposed Regulations

H. The Debt Limit Extension Act of 1989

I. Final Regulations - The Family and Medical Leave Act

J. 1996 Legislation

K. 1997 Temporary and Proposed Regulations on Cafeteria Plan Elections

L. Final Regulations On Applicability of COBRA to Medical FSAs

M. Final Regulations on Cafeteria Plan Elections

N. 2007 Comprehensive Proposed Regulations

III. General Requirements of a Cafeteria Plan

A. Purpose and Scope of Section 125

1. Safe Harbor From Constructive Receipt

2. Scope of the Section 125 Safe Harbor

a. Choice Among Nontaxable Benefits Only

b. Choice Among Taxable Benefits Only

B. Written Plan Required

C. All Participants Must Be Employees

1. Former Employees

2. Beneficiaries of Employees

3. Employees of Two or More Employers

4. Self-Employed Individuals

D. Choice Among Benefits

1. In General

2. Default Elections

3. Revocation and New Election Due to Change in Status

4. Revocation of Election Due to Certain Other Events

5. Irrevocability of Election: Insured as well as Uninsured Benefits

6. Change of Election Outside the Employee's Control

7. Change of Election and § 409A

E. Prohibition of Deferred Compensation

1. Common Types of Deferred Compensation

2. Deferred Welfare Benefits and Carryover of Benefits

F. Cafeteria Plan General Requirements Under the 2007 Proposed Regulations

1. Scope and Purpose

2. Plan Document Requirements

3. Employees Eligible to Participate

4. Plan Year Requirements and Grace Period

5. Election of Benefits

6. Prohibition of Deferred Compensation

a. Paid Time Off

b. Benefits Relating to More than One Year

7. Substantiation of Expenses

a. Cafeteria Plan Payments and Reimbursements

b. Cafeteria Plan Claims Substantiation Rules

c. Mandatory Rules for All Debit Cards Usable to Pay or Reimburse Medical Expenses

d. Substantiation of Expenses Incurred at Medical Care Providers and Drug Stores and Pharmacies

(1) Applicability

(2) Copayment Matches, Certain Recurring Medical Expenses and Real-Time Substantiation

(3) All Other Medical Expenses Paid or Reimbursed Through a Health FSA Debit Card

e. Inventory Information Approval System

f. Debit Cards Used to Pay or Reimburse Dependent Care Assistance

IV. Benefits Available Under a Cafeteria Plan

A. General Rule

B. Cash

1. Salary Reduction Agreements

a. Plan Assets Under ERISA

b. State Insurance Laws

c. Minimum Wage

2. Cash in Addition to Regular Salary

3. Taxable Benefits Treated as Cash

C. Medical Benefits

1. Types of Benefits

a. Comparison to Health Reimbursement Accounts

b. Qualified Reservist Distributions

c. Long-Term Care Insurance

2. Tax Treatment in General

a. Exclusion of Employer Contributions

b. Exclusion of Benefits

3. Advantage of Inclusion in a Cafeteria Plan

4. Special § 105 Rules for Self-Insured Medical Expense Reimbursement Plans

a. Self-Insured Medical Expense Reimbursement Plan

b. Forms of Discrimination

c. Excess Reimbursements of Highly Compensated Individuals

d. Relation to Cafeteria Plan Rules

e. Reimbursement Through Debit or Credit Card

5. Continuation Coverage Under COBRA

a. In General

b. Plans That Must Comply

c. Qualifying Events

d. Qualified Beneficiaries

e. Continuation Coverage

f. Applicable Premium

g. Duration of Continuation Coverage

h. Extended Coverage for Disability

i. Notice and Election Procedures

j. Sanctions

k. Applicability to Cafeteria Plans

6. Effect of the Family and Medical Leave Act on Health Plan Coverage

7. Health Insurance Portability and Accountability Act of 1996

a. Background

b. Overview of HIPAA

c. Applicability to Cafeteria Plans

D. Disability and Accident Benefits

1. Types of Benefits

2. Tax Treatment of Benefits

a. Tax Treatment in General

b. Disability Income Tax Credit

3. Advantage of Inclusion in a Cafeteria Plan

a. Dismemberment or Disfigurement Benefits

b. Disability Income Benefits

c. Accidental Death and Dismemberment Coverage

E. Group Term Life Insurance Coverage

1. General Description

2. Tax Treatment

3. Advantage of Inclusion Within a Cafeteria Plan

4. Summary of Section 79 Requirements

a. General Requirements

b. Requirements If Less Than 10 Full-Time Employees Are Covered

c. Nondiscrimination Requirements

F. Dependent Care Assistance

1. General Description

2. Tax Treatment in General

3. Advantage of Inclusion Within a Cafeteria Plan

a. General Desirability

b. Effect of Dependent Care Tax Credit

4. Requirements of Section 129

a. Dependent Care Assistance

(1) Qualifying Dependents

(2) Care of the Dependent, or Household Services

(3) Gainful Employment

(4) Member of the Household

(5) Dependent Care Center

(6) Care Provided by Child or Dependent

b. Dependent Care Assistance Program

(1) Separate Written Plan

(2) Nondiscriminatory Contributions or Benefits

(3) Reasonable Classification of Employees

(4) Limitation on Benefits for 5% Owners

(5) Notification of Availability and Terms

(6) Annual Statement of the Amount of Dependent Care Assistance

(7) Average Benefits Test

c. Limits and Conditions

G. Adoption Assistance

1. General Description

2. Tax Treatment in General

a. Dollar Limitation

b. Income Limitation

3. Advantage of Inclusion Within a Cafeteria Plan

a. General Desirability

b. Effect of Adoption Expense Tax Credit

4. Requirements of § 137

a. Qualified Adoption Expenses

(1) Qualified Expenses

(2) Eligible Child

b. Adoption Assistance Program

(1) Separate Written Plan

(2) Notification and Availability of Terms

(3) Nondiscriminatory Eligibility

(4) Limitation on Benefits for 5% Owners

(5) Claims Substantiation

c. Additional Conditions and Requirements

(1) Year of Exclusion

(2) Employer's Withholding and Reporting

(3) Employee's Tax Filing Obligations and TIN Requirements

H. Section 401(k) Cash or Deferred Arrangements

1. General Description

2. Federal Income Tax Treatment

3. Inclusion of a Cash or Deferred Arrangement in a Cafeteria Plan

4. Requirements of a Section 401(k) Cash or Deferred Arrangement

a. Qualified Profit-Sharing or Stock Bonus Plan

b. Nondiscrimination Tests

c. Immediate Vesting of Elective Contributions

d. Restrictions on Distributions of Elective Contributions

e. Additional Requirements of Section 401(k)

5. Additional Requirements of Section 125

I. Post-Retirement Group Life Insurance for Employees of Educational Organizations

J. Vacation Days

K. Qualified Cafeteria Plan Benefits Under the 2007 Proposed Regulations

1. Cash

2. Health Flexible Spending Account Rules

a. Health FSA Benefits

b. Coverage Rules

c. Experience Gains or Forfeiture of Unused FSA Benefits

3. Group-Term Life Insurance Coverage

4. Dependent Care Assistance

a. Coverage and Reimbursement

b. Experience Gains or Forfeiture of Unused Dependent Care Benefits

5. Section 401(k) Cash or Deferred Arrangements

6. Adoption Assistance Programs

7. HSA-Compatible FSAs, Limited-Purpose Health FSAs and Post-Deductible Health FSAs

8. Qualified HSA Distributions Under § 106(e)

V. Benefits Not Available Under a Cafeteria Plan

A. Nonqualified Benefits

B. Consequences of Including Nonqualified Benefits

C. Deferred Compensation

VI. Nondiscrimination Rules for Cafeteria Plans

A. General Description

B. Meaning of "Highly Compensated"

C. Nondiscrimination as to Eligibility to Participate

1. Safe Harbor for Collectively Bargained Plans

2. Safe Harbor Based on Coverage and Participation Rules

a. Nondiscriminatory Classification

b. Service Required for Participation

c. Entry Dates

d. Affiliated Employers

e. Combining Cafeteria Plans

3. Exclusivity of Safe Harbors

D. Discrimination as to Contributions and Benefits

1. Safe Harbor of Section 125(c)

2. Availability or Utilization

3. Testing Discrimination as to Contributions or Benefits

4. Toleration of a Limited Degree of Discrimination

5. Comparing Dollar Amounts or Percentages of Compensation

a. Special Rule for Health Benefits

b. Other Welfare Benefits

c. Section 401(k) Cash or Deferred Arrangements

6. Aggregate or Benefit-By-Benefit Approach

7. Combining Cafeteria Plans

8. Employer-Provided Core Benefits

9. Similarly Situated Employees

E. Consequences of Discrimination

1. In General

2. Allocation of Taxable Amounts to Benefits Actually Selected

3. Time of Inclusion in Gross Income

F. 2007 Proposed Regulations on Nondiscrimination in Cafeteria Plans

1. General Nondiscrimination Rule

2. Special Nondiscrimination Rule for Health Benefits

3. Nondiscrimination as to Eligibility to Participate

4. Nondiscrimination as to Benefits or Contributions

5. Nondiscrimination Testing

6. Anti-Abuse Rules

VII. Limitation on Nontaxable Benefits for Key Employees

A. General Description

B. Key Employees

1. Officers

2. 5% Owners of the Employer

3. 1% Owners with Annual Compensation Over $150,000

C. Application of the 25% Limitation

1. Contributions or Benefits

2. Aggregating Nontaxable Benefits Under the Plan

D. Consequence of Exceeding the 25% Limitation

VIII. Reporting Requirements

Introductory Material

A. Annual Return

B. Additional Information

C. Penalties for Failure to File

D. Recordkeeping Requirement

E. Labor Department Requirements

IX. Effect on Other Benefits

A. Social Security

B. Retirement Plans

C. Railroad Retirement

D. Other Benefits

X. State and Local Taxes


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Sample Cafeteria Plan

Worksheet 2 Sample Form of Benefit Election and Compensation Reduction Agreement, for use under the Cafeteria Plan in Worksheet 1

Worksheet 3 Sample Form for Revoking a Benefit Election and Compensation Reduction Agreement, for use under the Cafeteria Plan in Worksheet 1.

Worksheet 4 Sample Flexible Benefits Plan - with the same options as Worksheet 1, but also including Dependent Care Expense Reimbursements and Medical Expense Reimbursements

Worksheet 5 Sample Form of Election and Compensation Reduction Agreement - for use under the Flexible Benefits Plan in Worksheet 4

Worksheet 6 Sample Dependent Care Assistance Plan - Intended as an Option under the Flexible Benefits Plan in Worksheet 4

Worksheet 7 Sample Election Form - to elect Dependent Care Assistance under the plan in Worksheet 6

Worksheet 8 Sample Medical Reimbursement Plan - an Option under the Flexible Benefits Plan in Worksheet 4

Worksheet 9 Sample Election Form and Compensation Reduction Agreement - used to obtain Medical Expense Reimbursements under the plan in Worksheet 8

Worksheet 10 ABC Corp. Inc. Sample Enrollment Form for Dependent Care Salary Reduction Spending Account Plan (see also Worksheet 11).

Worksheet 11 Sample Employee Communications Materials: Questions and Answers About the ABC Corp., Inc. Dependent Care Spending Account Plan.

Worksheet 12 The ABC Corp., Inc. Enrollment Form for Salary Reduction Medical Expense Spending Account Plan (Flexible Spending Account)

Worksheet 13 Sample Employee Communications Materials: Questions and Answers about the ABC Corp., Inc. Medical Expense Spending Account Plan (Flexible Spending Account)

Bibliography

OFFICIAL

Principal Statutes:

Legislative History:

Committee Reports:

Other:

Regulations:

Treasury Rulings:

IRS General Counsel Memoranda:

Other IRS Releases:

Cases:

UNOFFICIAL

Periodicals:

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1998

1999

2000

2001

2002

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